On hoping you’ll be wrong
Forecasts are an assessment of the most likely outcome, not the preferred one. The ceasefire announcement was welcome, but whether it holds is highly uncertain.
- The economy does not care about your feelings, so forecasts must reflect what you think is the most likely outcome, not necessarily what you wish would happen. This distinction is especially salient now. The outright fall in global fuel supply has different implications than other recent supply shocks, and the outlook for Australia and the world is rough.
- The ceasefire announced this week was obviously welcome, but the question is whether the Strait of Hormuz opens properly. The first 24 hours after the announcement were not promising. But if it does, that would be a better outcome than the baseline forecast update we released last week. We would be happy if our baseline forecast was wrong for this reason.
- The key issue for Australia, and for the domestic interest rate outlook, is how much of the energy price shock is already being passed through to prices of other goods and services. The RBA will be watching for this kind of behaviour, including through its liaison program, and will see it as a further leg up in underlying inflation from a rate that was already higher than desired.
The thing about forecasting is that your preferences do not matter. A baseline scenario is simply what you think is most likely. It is not necessarily what you wish would happen. And of course things could play out differently. It is the role of scenario and risk-sensitivity analysis to articulate these other possible future states of the world.
The disconnect between what you hope will happen and what you think will actually happen is especially salient now. The near-term outlook for Australia is tough: higher inflation, with consumers again squeezed by some combination of higher interest rates, lower income growth and higher unemployment. Things are even worse for many other countries. Australia has been able to leverage its LNG exports to ensure we have – so far – not been left short of other fuels. Many lower-income countries do not have this advantage and have been facing the prospect of shortages and rationing; some of our neighbours in the Pacific are particularly hard-hit.
The economic shock from the Gulf conflict centres on global oil and gas supply. It is different from COVID, when the disruptions were all the way down supply chains. It also differs from the energy shock following Russia’s invasion of Ukraine, where the Russian oil and gas supply did not disappear, it just needed time to be redistributed to non-European nations willing to buy it despite the sanctions; the peak decline in its oil output was estimated to be around 3 million barrels per day, but the disruption faded quickly. This time around, the oil and gas are not getting out of the Persian Gulf. Some production has been redirected through Saudi pipelines to other ports, but not all of it. Current estimates are that the net reduction of global production has been 8–9 million barrels per day for oil and one-fifth of pre-war global supply for gas. And at the same time, Russia’s output capacity has been reduced by successful Ukrainian attacks on Russian oil infrastructure; news reports suggest this has cut global output by a further 0.7–1 million barrels per day.
The effect on prices from such a cut to capacity was always going to be severe.
News this week that a two-week ceasefire had been agreed was obviously welcome. Assuming it holds well enough to reopen the Strait of Hormuz properly – a big if given the attacks in the 24 hours following its announcement – it would be a better outcome than the baseline update we released last week, and one of the “risks on both sides” we contemplated when we released it. A lasting ceasefire and faster opening up of the Strait would put energy prices on a trajectory between the one we contemplated in last week’s baseline, and the one underpinning the forecasts in the March Market Outlook. A return to pre-war prices is unlikely in the short term, though, given the damage to oil and gas infrastructure in the Gulf states and in Russia.
Even if the ceasefire holds well enough that the Strait stays open, a key watchpoint is whether ships enter the Gulf during the next two weeks, not just whether those previously stuck there leave. If ships do not enter, the next wave of production will not be able to be shipped. Supply will sag again a few weeks later and prices will rebound, especially for refined product.
If the ceasefire does not hold, the reprieve on fuel supply will be brief. Trust between the parties is low and Iranian control of the Strait – even jointly with Oman – is an unstable equilibrium that is unacceptable to much of the rest of the world. Even if the ceasefire gets back on track after its rocky start, flare-ups later in the year cannot be ruled out.
The real question for Australia, and for the domestic interest rate outlook, is how much of the energy price shock is already being passed through to prices of other goods and services. On this there is less cause for optimism. While ‘temporary fuel levies’ are easier to unwind as fuel prices decline, for many products, list prices have been lifted significantly and a reversal seems less likely. Building materials are a particular issue, with the cost of building a detached home increasing as much as 10%, on our preliminary estimates. The lift in pricing has been widespread across industries and in some cases quite large relative to overall inflation trends. The RBA will be watching for this kind of behaviour, including through its liaison program, and will see it as a further leg up in underlying inflation from a rate that was already higher than desired.
Our next forecast round, scheduled for release next week, will contemplate both the case where traffic through the Strait remains disrupted and one where the ceasefire holds.
If the ceasefire does hold, downside risks to growth diminish and inflation risks ease. Because of the downstream pass-through to other prices we are already seeing, though, the inflation risks do not disappear and the RBA is still likely to raise the cash rate further. Still, it would be a better outcome than our current published baseline. This would be one of the instances where we would be quite happy to be wrong.
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